The recent strong performance by the stock markets has reduced the number of appealingly priced stocks to choose from these days. That certainly fits IDEX (NYSE:IEX), as this mid-cap industrial conglomerate has ridden a one-third move in its stock price to a recent new 52-week high. Although not so expensive that it's a short or a must-sell, patient investors may want to relegate this name to a watch list. The company's deep customer relationships and diverse industrial exposures are attractive, but not necessarily at today's valuation.
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Sluggish Fourth Quarter Results, but Orders Turning Back up
Although IDEX has generally been able to generate growth in excess of global gross domestic product, it's certainly not independent of the larger world, and the global slowdown has shown up in the company's results.
Revenue rose 2.12% as reported for the fourth quarter, but organic revenue was essentially nonexistent. Fluid and Metering (FM) saw a 1% decline in reported and organic revenue, while Health and Science Technologies (HST) saw 6% reported growth but 3% organic contraction. Fire & Safety/Diversified was the strongest segment this quarter, as revenue rose 9% as reported and 10% organically.
While sales may have slowed to a near-crawl, the company's efforts to squeeze out costs and drive better margins are paying off. Gross margin improved by a point, while operating income increased by 6%. Operating margin improved by about 70 basis points (BPS), with segment profit margins up 80 BPS. Profits were down 2% in HST, but up 5% in FM and up 19% in the Fire et al business.
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Perhaps even more importantly, orders rebounded this quarter. While the order decline in the third quarter was the first in three years, orders increased 5% this quarter on an organic basis.
Shouldn't Health Be Stronger?
I was disappointed to see the performance in HST this quarter. This is a business that gets more than a third of its sales from products/components used in analytical instruments like mass spec and liquid chromotography, as well as other applications in healthcare, food/pharma and life sciences.
While the company doesn't discuss its customers, performance has generally tracked that of large instrumentation/life science vendors like Agilent Technologies (NYSE:A), Waters (NYSE:WAT), Danaher (NYSE:DHR) and Life Technologies (Nasdaq:LIFE). Admittedly this hasn't been a banner quarter for the sector, but Waters' low single-digit revenue growth, Life Tech's 4% organic growth and Danaher's 7% core life sciences growth seem to suggest that performance should have been better at IDEX this quarter.
On the whole, I don't think this is any reason to panic. The high-precision components that IDEX makes (like injectors and valves), are not easily replaced in systems in the middle of a product cycle and companies aren't going to swap out IDEX components to save a few bucks. The parts aren't all that expensive, and it doesn't make long-term sense to skimp in areas that could lead to system failure.
The optics and photonics segment of HST is a different kettle of fish, though. Defense, electronics and consumer electronics are all still in the doldrums and did IDEX no favors this quarter. These markets should pick up (though perhaps not defense in the near term). However, getting CVI Melles Griot (a large acquisition from IDEX's recent past) back on track, will likely be a key part of improving performance.
Waiting on Recoveries in Industrial and Municipal
IDEX's broad industry exposure is generally a positive mark in its favor, but it hasn't really given the company a hiding place right now. Demand in the chemicals industry (about 10% of total revenue), automation and general industrial has softened up overall, as investors have certainly seen at IDEX comparables/peers like Danaher, Illinois Tool Works (NYSE:ITW) and Dover (NYSE:DOV), where low single-digit organic growth seems to largely be the order of the day.
Here too, the nature of the company's business argues for patience. IDEX works closely with its customers and often develops customized products to meet their needs - leading to relatively sticky business. On the other hand, the company has relatively low aftermarket exposure (about one-fifth of sales), and that means that it cannot rely so much on a stream of replacement orders when the economy slows and companies get jittery about committing to new capital investments.
Municipal spending trends are also doing the company no favors right now. Plenty of companies, including Gorman-Rupp (AMEX:GRC), Watts Water Technologies (NYSE:WTS), General Electric (NYSE:GE) and IDEX, have been waiting on a municipal spending recovery in the water and wastewater markets that has yet to really materialize. While everybody seems to agree/believe that this is an attractive market for the long term, municipalities are proving that they can go longer between capital investments than previously believed. With about 10% of IDEX's overall revenue tying back to water and wastewater, it's not a trivial concern for investors.
Control What It Can - Costs, Capital and Consumables
IDEX can't really create its own demand, so it behooves management to focus on the aspects of the business where it can exercise meaningful control. In this company's case, I believe that centers on cost control, capital allocation and shifting the business mix.
On the cost control side, management is already in the middle of a cost-cutting restructuring that looks to add a point or two to peak margins (previously 18.8%). Management has already moved some manufacturing to lower-cost regions and improved its sourcing. I suspect there's still more to be gained in better integration of past acquisitions (more than half of the company's historical revenue growth has come from acquisitions).
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On the capital side, management spent more than $900 million on deals over the past five years, with nearly half of that going to the as-yet unimpressive CVI Melles Griot deal. Looking back, about 70% of cash flow has gone toward mergers and acquisitions (M&A), and management has earmarked about $1.5 billion to be spent over the next three years on M&A, dividends and buybacks. While M&A probably will remain the preferred use of capital (more than 50%), I would think dividends will also be heading higher, as management has talked about paying out 30% of earnings.
Last and not least, I'd look for management to work to increase the company's percentage of aftermarket sales. This won't be something that the company can change overnight, or even over a few years. However, IDEX has a large installed base of pumps and other products around the world, and I think it would be good for sales, margins and cash flow to figure out how to create a more lasting cash flow stream from those sales.
The Bottom Line
Low fixed-asset leverage has hampered IDEX's return on invested capital, and that's not uncommon for active acquirers. At the same time, I'm not confident that the company can dramatically exceed a long-term target of mid-single-digit growth for revenue or cash flow. That points to a fair value in the mid to high $40s, which is not too compelling against today's $48 price. Should the company find a way to better utilize its existing resources and/or outperform on the cost-cutting, there could be upside into the $50s.
I wouldn't sell IDEX if I owned it today, but even a target in the $50s doesn't suggest a need for investors to rush to own these shares today. I'd love to reconsider this stock at a lower price, but for now it will sit on the watch list.
At the time of writing, Stephen D. Simpson did not own shares in any company mentioned in this article.